NavStar Currents

Risk vs. Reward

Alan thought everything was great. It was August of 2008 and he was just about there! In three months he'd be putting in his retirement papers- he finally had a million dollars in his retirement account. Now, with a "properly balanced" portfolio, he'd be able to take a 4% drawdown against that portfolio for the rest of his life. His stockbroker had assured him of that. This money, along with social security, would put him in fine shape. In three months he'd "stick it to the man!"

Now let's move ahead 2 years. It's the middle of 2010 and Alan can scarcely believe how his retirement is going so far. He had done just as he planned...marched into HR and announced his retirement in November of 2008, even though the stock market was in a free-fall at the time. His broker had assured him not to worry: "it wil come back." Well, it hadn't. Alan was still taking that same $40,000 a year from his portfolio. The only problem was that his portfolio had lost 45% of it's value. His million dollars was now down to almost $500,000. That meant that his rate of drawdown, instead of being 4% was now over 7%. Even that, however, wasn't the worst news. Last month his wife was diagnosed with Alzheimers disease. She would almost certainly have to be institutionalized, and it wasn't cheap. His income right now was a little over $7000 a month. The facility for his wife was $6500.

In desperation Alan was now looking for a job. He desperately needed to go back to work, but as he was beginning to discover, even though he had been a highly qualified software engineer, nobody wanted to talk to him because of his age.

In only two years his wonderful plan for retirement had been dashed on the rocks. What was he going to do? A million dollars had seemed like so much.

The unknown variable for Alan was how much investment risk, he was exposed to. This is the "elephant in the room" that no stockbroker likes to talk about.

Which would you rather have, low-risk and low-volatility along with some peace of mind, or high-risk and high-volatility along with screaming highs and screaming lows?

That question summarizes the difference between the world of tactical money management versus modern portfolio theory which says you must buy and hold, no matter what.

What do I mean by tactical money management? It's simply active management, as opposed to passive. Let me give an example: in 2008 were you wondering why your stockbroker left your entire portfolio exposed as the market declined by more than 50% in just a few months? He was practicing "passive" management (an oxymoron). He'd speak words such as, "don't worry, it'll come back." He was right. The market did rebound...IN 5 YEARS! If you were a retiree living on a fixed income, and perhaps facing some serious issue such as long-term care expenses, were you able to not worry when your $1 million portfolio became less than $500,000? That was a long five years.

The Hare vs. the Tortoise

Let's face it, Wall Street is sexy. Where else can the lure of 150% returns and the calculation of standard deviation, variance, and geometrically weighted returns create such excitement? Wall Street is the red Ferrari, the F-16 fighter, the Rocky Balboa of earning money. Just remember that Rocky took some hard knocks along the way!

But what about "good old, boring life insurance?" Can it be a good investment?

Many advisors today would tell you that the answer to that question is no. Certainly those advisors who also happen to be stockbrokers would say that. But our parents would have had a different idea. To the “greatest generation” the idea of risking money in the market brought back unpleasant memories of losing everything in the great depression.

But it's just not sexy, insurance. Ugh! Why would anyone want the tortoise when they can have the rabbit?

Are you a risk taker?

If you have investments on Wall Street, you are. You might not be a skydiver, scuba diver, or venture capitalist, but you're a risk taker. Your money is at risk of loss. Investors know that the amount of money they are likely to earn on their investment is directly related to the amount of risk they are willing to accept to generate that return.

What continually amazes me, however, is how misinformed most investors have as to the amount of risk they actually have. I'd say that 75% of the folks I interview who tell me they are "very conservative" when it comes to their tolerance for risk, have no idea that their stockbroker has them heavily invested in high to moderate risk funds!

We know that we need to take some risk. What we don't seem to know is this: we should always take the least amount of risk necessary to generate a required return. In other words, if you can earn 8% a year taking a low risk, why on earth would you want to take a moderate risk to get that same 8%?

In a sane world, you wouldn't. Is your broker living in a sane world?

Are you a risk taker?

If you have investments on Wall Street, you are. You might not be a skydiver, scuba diver, or venture capitalist, but you're a risk taker. Your money is at risk of loss. Investors know that the amount of money they are likely to earn on their investment is directly related to the amount of risk they are willing to accept to generate that return.

What continually amazes me, however, is how misinformed most investors have as to the amount of risk they actually have. I'd say that 75% of the folks I interview who tell me they are "very conservative" when it comes to their tolerance for risk, have no idea that their stockbroker has them heavily invested in high to moderate risk funds!

We know that we need to take some risk. What we don't seem to know is this: we should always take the least amount of risk necessary to generate a required return. In other words, if you can earn 8% a year taking a low risk, why on earth would you want to take a moderate risk to get that same 8%?

In a sane world, you wouldn't. Is your broker living in a sane world?

Have you ever wondered why your broker doesn't protect your portfolio when the market is crashing?

It seems like a reasonable question to me. In 2008-09 when the market was in a serious free-fall the protection that the average investor thought he had through diversification was absent. That's because diversifying your portfolio is no protection when the entire market is declining. Many portfolios declined by half. It wasn't pretty.

Yet, the mutual funds that constitute the vast majority of American investment remained 100% in the market. You'd think that a professional fund manager would move to protect his clients, but the investor usually expects his stockbroker to do that. The average stockbroker, however, is constrained by the firm he works for. It's a fact that most mutual funds stay at least 80% invested in the market, even when it's crashing.

Why?

Did you know...

that before 1980 less than 5% of Americans were invested in the stock market? That's kind of hard to believe when you've just seen the latest report on the Dow in the evening news, followed by several commercials from investment firms, and even a cable channel devoted to Wall Street!

But our parents were probably not part of all this. They accumulated wealth in more traditional ways, and took much less risk. Why do we take such risk with our money today? Because we have been educated by the Wall Street machine to believe that we have to.

As an investment advisor, and a financial planner, I would agree that over the long-term there isn't a better way to grow assets than in the market, which has traditionally returned north of 7% year after year OVER THE LONG HAUL. But what if you are a retiree, or getting close to retirement? Can you really be happy about losing half of your portfolio in a few months, and then waiting six years for it to come back? That's what happened in 2008-09. What if you suddenly had to pay for long-term care just as your portfolio hit bottom? Would you still be excited about Wall Street? By the way, in the 30's, after the stock market crash, an entire generation never trusted Wall Street again, or banks!

All Good Things Must Come to an End

The statement above does not, however. apply to our latest political season. Most Americans would agree that the last election was, in fact, been quite ugly, no matter which side of the fence you were slinging mud from. I learned one very important lesson through it all....if even half of what the campaign ads proclaimed is to be believed, THERE WAS NOBODY WORTHY OF BEING ELECTED TO ANYTHING!

But that's beside the point. This is a financial blog, and you're probably saying something to yourself like, "get to the point, Larry, or I'm going back to watch Cramer on MSNBC." So here goes...

Risk vs. Reward

Alan thought everything was great. It was August of 2008 and he was just about there! In three months he'd be putting in his retirement papers- he finally had a million dollars in his retirement account. Now, with a "properly balanced" portfolio, he'd be able to take a 4% drawdown against that portfolio for the rest of his life. His stockbroker had assured him of that. This money, along with social security, would put him in fine shape. In three months he'd "stick it to the man!"

Now let's move ahead 2 years. It's the middle of 2010 and Alan can scarcely believe how his retirement is going so far. He had done just as he planned...marched into HR and announced his retirement in November of 2008, even though the stock market was in a free-fall at the time. His broker had assured him not to worry: "it wil come back." Well, it hadn't. Alan was still taking that same $40,000 a year from his portfolio. The only problem was that his portfolio had lost 45% of it's value. His million dollars was now down to almost $500,000. That meant that his rate of drawdown, instead of being 4% was now over 7%. Even that, however, wasn't the worst news. Last month his wife was diagnosed with Alzheimers disease. She would almost certainly have to be institutionalized, and it wasn't cheap. His income right now was a little over $7000 a month. The facility for his wife was $6500.

In desperation Alan was now looking for a job. He desperately needed to go back to work, but as he was beginning to discover, even though he had been a highly qualified software engineer, nobody wanted to talk to him because of his age.

In only two years his wonderful plan for retirement had been dashed on the rocks. What was he going to do? A million dollars had seemed like so much.

The unknown variable for Alan was how much investment risk, he was exposed to. This is the "elephant in the room" that no stockbroker likes to talk about.

Which would you rather have, low-risk and low-volatility along with some peace of mind, or high-risk and high-volatility along with screaming highs and screaming lows?

That question summarizes the difference between the world of tactical money management versus modern portfolio theory which says you must buy and hold, no matter what.

What do I mean by tactical money management? It's simply active management, as opposed to passive. Let me give an example: in 2008 were you wondering why your stockbroker left your entire portfolio exposed as the market declined by more than 50% in just a few months? He was practicing "passive" management (an oxymoron). He'd speak words such as, "don't worry, it'll come back." He was right. The market did rebound...IN 5 YEARS! If you were a retiree living on a fixed income, and perhaps facing some serious issue such as long-term care expenses, were you able to not worry when your $1 million portfolio became less than $500,000? That was a long five years.